To Bet Or Fold: Where Sentiment Lies In Stock Analysis

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Includes: FXE, WETF
by: Philipe Saroyan

Summary

Understanding CAPM and sentiment.

What is investor sentiment.

Value-added sentiment.

In the context of stock analysis, sentiment lies somewhere in between technical and fundamental analysis, which begs the question: what is the context?

In the case of sentiment, we must understand that stocks effect sentiment, however, sentiment doesn't fundamentally effect prices.

According to research from Allis, P. and McCallig, J. (2007), sentiment can only be a factor in the long-run, but not in the short-run. Their reasoning is that sentiment is not an economic input, only so much as it becomes a wealth effect, can it effect prices fundamentally.

In recent research, I discover that the proprietary Options Sentiment Indicator (OSI) is able to partially explain a part of the noise in the Social Media Factor, defined by Social Market Analytics. In other words, it can potentially help understand the variable itself, but is peripheral in comparison to the actual Social Media Factor. The OSI is a market sentiment indicator, which is comprised of the daily open interest of the underlying ETF, namely the Euro ETF (NYSEARCA:FXE). Because the Euro is one of the most liquid trading vehicles in the world, options and social media can be a strong predictor variable for intraday price swings of the Euro. It's a noise trading indicator, with no suggestions for momentum, or overnight holding periods; every day is a new day.

The big question mark for sentiment researchers and traders, is where does the value in the sentiment variable lie? The answer is, the inherent psyche of financial markets. When keeping all other variables constant, speculation becomes a highly psychological endeavor. Who's to say that any one stock should trade wildly above its average P/E ratio or book value price? Value investors certainly can't justify a far above average ratio. And, growth investors also couldn't reasonably quantify a value as to what is a true equilibrium price for a major growth stock. This is where sentiment indicators can become invaluable. Just like any other technical indicator, sentiment can bring stock prices and its history into context.

DISCOUNTING FACTORS

To categorize each known variable and discount based on each factor, is the work of a fund research company.

They rank funds based on investment category, style, size, stewardship, performance, etc. If a research can rank funds based on style, it's only reasonable to say that the same can be true for sentiment. The problem is people have yet to come to a sentiment measure that is widely accepted, there is still dissent as to the methodology and true sentiment factor.

With that said, CBOE and Social Market Analytics, have recently launched their second benchmark index for the social media factor. An equally-weighted index of the top 25 large-cap stocks based on SMA sentiment scores, the index (SMLC) is of particular interest because it focuses on weekly sentiment. Their data analytics have proven to be a viable proxy for sentiment, and weekly sentiment is a great way for generating greater returns as an investment strategy.

INVESTOR SENTIMENT

It's important to understand, investor sentiment, consumer sentiment, and the social media factor are all different things. In short, financial literature defines investor sentiment as something to do with the very reason stockholders would loosen their purse strings to add more shares, divest, or buy another company. Whereas, social media sentiment, is a more of consensus-building of all "investors" in the market.

Consumer sentiment has more to do with buying behavior in retail stores and for personal goods, not necessarily for investors. Still, consumer sentiment is very much relevant for understanding sentiment indicators. Consumer sentiment is a leading indicator for the economy, investor sentiment is the willingness or attitude of accredited investors, and social media sentiment is like the neurological pattern of stock prices.

For professionals, it isn't necessarily how high the index or price value goes, but the make-up of stock traders. If most of the trading is comprised of liquidity providers, and there is a positive correlation with sentiment; then, from a research standpoint, portfolio managers can make an informed decision what proportion of a stock's price can be attributed sentiment. Invariably, this pocket of value could eventually be discounted, all else remaining equal, and, notwithstanding long-term wealth effects from positive sentiment.

So, for hedge funds and long-short funds, it becomes an added weapon in their arsenal. Visualizing sentiment data makes these research-based decisions almost instantaneous, at first glance.

DISCOUNTING SENTIMENT

Being able to keep the sentiment factor constant and discount a portfolio based on this factor, just as one would with market cap. or investment style, is also a value driver. So far, it hasn't been widely accepted in the traditional Capital Asset Pricing Model (CAPM). It has been received with mixed reactions. However, with recent interest in institutional fund sales, and fund offerings, the social media factor, is, without a doubt, able to add value to an investment portfolio. Just as point & figure charts, and other known technical indicators, sentiment can be a guide for determining relative value. For sentiment traders, it is invaluable to know the difference between trading action derived from sentiment, versus what is a fundamental shift in value.

SMART BETA

This brings us back to Wisdom Tree Asset Management (NASDAQ:WETF), if you saw any of the developments from the last bull market, you will know that portfolio management is a much more sophisticated form of investing. Notwithstanding speed trading, portfolio managers are able to add value by indexing and capturing alpha.

Because it is hard to know precisely what beta risk is, their approach is to better expose themselves to minimize beta, as well as discount for value-added factors. For instance, indexing for such value drivers as market cap., or book to market value, their portfolios are able to capture performance before any managers even go after the alpha returns.

In their writing, they describe this value indexing approach as SMART Beta, an efficient risk exposure that captures more of the return by methodically indexing the portfolio with a global focus.

Although, the sentiment factor is not necessarily beta or alpha, some research does find it to be a viable beta variable in an asset pricing model. It's just less definitive than other known variables like market cap. and book to market ratios.

For sentiment traders it is valuable because comparative sentiment indicators tell a story of liquid assets, when fundamental news is on a back-burner.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.